Constraints on Asset Allocation

Real World Issues

Real-world events often cause deviations from the optimal asset allocation the mathematical calculations of modern portfolio theory suggest. This section delves into the reasons behind these deviations and explores the timing and circumstances in which they occur. In addition, this section guides financial professionals on effectively managing deviations in real-world events.

Additional Constraints When Choosing an Optimal Asset Allocation

Asset Size

Smaller portfolios may face limitations in accessing a wide range of investment options. Due to factors such as a smaller asset base or constraints local regulations impose, these portfolios may struggle to achieve sufficient diversification. Additionally, smaller funds may lack the financial resources to hire top-level management and governance expertise, further impacting their investment capacities. In contrast, more considerable funds benefit from economies of scale and greater negotiating power, enhancing the advantages mentioned earlier.

However, specific investment strategies, such as small-cap active equity management, may be more suitable for smaller funds. These strategies may be better equipped to accommodate investments of meaningful size for smaller funds, making them relatively more accessible than large ones.

Liquidity Needs

The requirement for quick access to funds imposes limitations on the available investment options within a specific asset allocation. Certain institutions, including banks, property, and casualty insurers, face significant liquidity demands. They must be prepared to meet deposit withdrawals and insurance policy claims, which are often unpredictable. Consequently, these investors focus on shorter-term, more liquid investments with lower yields, such as treasury bills. On the other hand, sovereign wealth funds typically have longer investment horizons and lower liquidity requirements. Unlike property and casualty insurers, life and auto insurers have greater predictability within their risk pool. As a result, they can strategically position themselves to capture illiquidity premiums associated with alternative investments.

Asset managers should consider the potential for changes in investor behavior during periods of market turmoil. During crises, investors may exhibit panic-selling behavior, withdraw deposits in large numbers, or make irrational decisions driven by fear and uncertainty. Failure to account for these reactive actions could result in underestimating the average liquidity needs. Therefore, asset managers must be aware of the potential impact of such behavior and incorporate it into their assessment of liquidity requirements.

Time Horizon

Time horizons play a crucial role in asset allocation decisions. When upcoming liabilities or funding goals are closer, the time horizon shortens while it extends for those farther into the future. Generally, longer time horizons provide a greater capacity to tolerate risk. This allows for allocating more riskier asset classes like alternative investments and equity. In the fixed-income space, longer time horizons are associated with higher durations, enabling investments in lower credit-quality bonds. It is crucial to align the time horizon with the duration of the specific investment under consideration.

The optimal allocation of financial capital can change over time when asset allocation considers extended portfolio assets such as human capital (Bodie, Merton, and Samuelson 1992). As the bond-like risk of human capital decreases over time, assuming the investor’s utility function remains unchanged, the asset allocation for financial capital would gradually shift towards bonds. This demonstrates how time horizon can affect asset allocation Regulatory and Other External Constraints.

As an investor’s priorities change over time, their asset allocation decisions will likely change due to human capital, financial market considerations, and changes in their priorities.

Regulatory and Other External Constraints

Insurance Companies

Insurance companies rely heavily on the investment returns of their portfolios, also known as return on the float. Portfolio investment returns contribute significantly to insurance companies’ net income. Insurance companies aim to immunize liabilities by ensuring they can meet future obligations. As a result, insurance companies typically have a significant allocation to fixed-income investments. Regulatory restrictions often limit the risky assets these companies can invest in. While meeting future liabilities is paramount, other factors, such as the insurer’s financial health and ability to quickly liquidate assets, also play a role in determining the asset allocation strategy.

Pension Funds

Pension funds are subject to extensive regulation, given their critical role in providing retirement funding. Regulators closely monitor these funds to ensure the security of promised benefits. As a result, pension funds generally prioritize conservative investment strategies, which limit allocations to higher-risk assets. Instead, they focus on high-quality bonds with lower durations and yields, ensuring stability and minimizing potential volatility.

Endowments and Foundations

Endowments and foundations are known for their relatively low investment constraints compared to other investors. With an often perceived infinite time horizon, these institutions have greater flexibility in their asset allocation choices. They can explore investment opportunities across asset classes, including equity and alternative investments. While some jurisdictions may impose minimum withdrawal requirements, these institutions enjoy more freedom in their investment decisions.

Tax incentives and creditworthiness considerations may influence the asset allocation decisions of an endowment or foundation.

• Tax incentives: Many countries provide tax benefits to endowments and foundations that meet minimum spending requirements. These requirements may be relaxed if certain socially responsible investments are made, creating a bias towards such investments for some endowments and foundations.
• Credit considerations: Endowments and foundations have a long investment horizon, but external factors may limit risk-taking. For example, lenders may require borrowers to maintain minimum balance sheet ratios, so the organization’s asset allocation considers the risks of breaking bond covenants or negatively affecting borrowing capabilities.

Sovereign Wealth Funds

Sovereign wealth funds act as investment vehicles for the citizens of a specific country. Although they are not legally bound to align assets and liabilities like pension funds and insurers, these funds face constraints due to public scrutiny within their jurisdictions. Many funds limit socially responsible investing, setting minimum allocations in this area. They also have maximum limits on investments denominated in foreign currencies and exposure to riskier asset classes like private equity or hedge funds. These restrictions are in place to maintain a certain level of prudence and accountability in their investment strategies.

Asset allocation choices are constrained by asset size, liquidity, time horizon, regulations, culture, religion, and ESG considerations. Sharia law prohibits investment in businesses linked to pork, alcohol, tobacco, pornography, prostitution, gambling, weaponry, interest payments, and risk transfer.

ESG goals are usually not considered during the asset allocation process. They can be achieved through implementation or by setting aside a portion of assets for these missions. This “set-aside” is treated like a concentrated stock position and becomes an asset class with specified characteristics and minimum investment constraints.  

Question

Which of the following institutions faces the least liquidity constraints in asset allocation?

1. Banks.
2. Property and casualty insurers.
3. Life insurers.

Solution

The correct answer is C:

Life insurers have a more predictable overall risk pool than banks and property and casualty insurers. They, therefore, have relatively lower liquidity needs.

A is incorrect: Banks have extremely high liquidity needs since they must stand ready to repay customer deposits and carry out their day-to-day operations.

B is incorrect: Property and casualty insurers experience more unpredictability of claims than life insurers, increasing their liquidity needs.

Asset Allocation: Learning Module 5: Asset Allocation with Real-World Constraints; Los 5(a) Discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as constraints on asset allocation